More in Innovations in Finance: Exchanges

Yet it is the envy of many because it has something exchanges in the world's other leading financial markets lack: a tight link to China.

As stock exchanges around the world struggle to innovate or rush to merge because of increasing competition, Hong Kong Exchanges & Clearing Ltd.'s connection to China has allowed it to stay above the fray. "Hong Kong Exchanges' future is strongly linked to the continued development of capital markets in mainland China," says UBS AG analyst Stephen Andrews.

The bet on China has paid off so far. Chinese companies account for two-thirds of the equity-trading volume in Hong Kong. Global companies eager to associate themselves with the China growth story, and Chinese companies looking to raise their international profile, are all listing on the city-state's monopoly exchange. The result: Hong Kong is leading the world in total value of new listings this year, as it did for both 2009 and 2010.

That has helped the exchange's operator, also known as HKEx, become one of the most profitable in the world, with pretax operating margins this year expected to reach 77%, compared with the global average of 63% and NYSE Euronext's 48%, according to research from Credit Suisse Group AG.

Brewing Problems

The Hong Kong exchange's achievements come despite its relative lack of technological prowess and high trading costs—two issues at the forefront of competitors' minds.

ENLARGE

Hong Kong is as much as two years behind its rival Singapore Exchange Ltd. in terms of improving and updating its trading platforms and data centers, says Credit Suisse analyst Arjan van Veen, who covers both exchanges. "HKEx is currently undertaking a decade of IT investment over the next few years" in an effort to catch up, he says.

A hefty government-imposed tax, meanwhile, makes it so expensive to buy and sell shares on Hong Kong's bourse that the high-speed traders who feature prominently in other markets can't operate there. The average cost of trading large-cap stocks was more than 40% higher in Hong Kong than it was in the U.S. in the second quarter of 2011, according to Investment Technology Group, a global broker and provider of independent trade-cost analytics.

Meanwhile, critics say the very thing that has buoyed the Hong Kong exchange so far—its link to China—could become a big negative in the years ahead.

Last year, HKEx announced plans to allow locally listed Chinese companies to prepare their financial statements using Chinese accounting standards and to have mainland auditors vet them. Some market participants have criticized the decision. They say bringing mainland audit firms to Hong Kong could erode investors' confidence in the quality of Hong Kong's capital markets, particularly amid allegations of fraud at some Chinese companies listed overseas, and reduce the regulatory power of Hong Kong's watchdogs.

Hong Kong Exchanges Chief Executive Charles Li says investors shouldn't look at such initiatives in isolation but rather as part of a broader strategy to prepare Hong Kong to reap the benefits of the eventual opening of China's capital account, which he believes will spur massive investment in Hong Kong. "Our goal is to be the international exchange of choice for Chinese investors, and the China exchange of choice for international investors," he says.

Two-Way Street?

Not everyone believes Hong Kong will benefit once China opens it capital markets, however. Some say Hong Kong could be eclipsed by exchanges on the mainland once China loosens its capital controls. Their argument is that Hong Kong is helping China develop its capital markets, but once China is up to speed and its currency is fully convertible, who will care about the tiny territory?

It's a double-edged sword, says UBS's Mr. Andrews. "If the capital account opens, there is just as much chance of liquidity migrating to Shanghai for dual-listed stocks as remaining in Hong Kong," he says. "There is no reason to believe the relationship between Shanghai and Hong Kong will remain 'friendly' when the two exchanges start competing directly for liquidity."

Mr. Li prefers to describe the capital-account opening as a two-way street. "When people talk about China eclipsing Hong Kong they just talk about people investing in China, but they forget that Chinese investors will also come to Hong Kong," Mr. Li says. Ultimately the exchange will come out ahead, he says. "We will lose some of our market, but we will gain a lot more."

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